05

Market Failures: Public Goods and

Externalities

McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved.
 Market Failures
• Market fails to produce the right
amount of the product
• Resources may be
• Over-allocated
• Under-allocated

LO1 5-2
 Market Failures
• Demand-side Market Failures
– Demand curves do not reflect consumers’ full
willingness to pay for a good or service.

• Supply-side market failures

– Supply curves do not reflect the full cost of producing
a good or service.

LO1 5-3
 Demand-Side Failures

• Impossible to charge consumers what

they are willing to pay for the product

• Some can enjoy benefits without paying

• E.g. Outdoor firework displays

LO1 5-4
 Supply-Side Failures

• Occurs when a firm does not pay the

full cost of producing its output
• External costs of producing the good
are not reflected in the supply

• Coal-burning power plant: land, labor,

capital… the smoke that it releases into
the atmosphere

LO1 5-5
 Efficiently Functioning Markets

• Two conditions:
– Demand curve must reflect the consumers full
willingness to pay

– Supply curve must reflect all the costs of

production

LO1 5-6
 Consumer Surplus

• Difference between what a consumer is

willing to pay for a good and what the
consumer actually pays

• Extra benefit from paying less than the

maximum price

LO2 5-7
 Consumer Surplus
• The maximum price that a person is willing to pay for a
unit of a product depends on the opportunity cost of that
person’s consumption alternatives.
• Utility surplus arises because each consumer who buys
the product only has to pay the equilibrium price even
though many of them would have been willing to pay
more than the equilibrium price to obtain the product.

LO2 5-8
 Consumer Surplus

Demand curve: the lower the price, the greater the total quantity
•At a price of $12.50, for instance, Bob will be the only person listed in the
table who will purchase a bag
•At a price of $11.50, both Bob and Barb will want to purchase a bag.
•At a price of $10.50, Bob, Barb, and Bill will each want to purchase a bag.

LO2 5-9
 Consumer Surplus

Consumer
Surplus
Equilibrium
Price
P1

Q1

LO2 5-10
 Consumer Surplus

• Consumer surplus can also be defined as the area that lies below the
demand curve and above the price line that extends horizontally from
P1.

• Consumer surplus and price are inversely (negatively) related. Given

the demand curve, higher prices reduce consumer surplus; lower prices
increase it.

LO2 5-11
 Producer Surplus

• Difference between the actual price a producer receives

and the minimum price they would accept

• Extra benefit from receiving a higher price

• A producer’s minimum acceptable price for a particular unit

will equal the producer’s marginal cost of producing that
particular unit.

• Marginal cost= opportunity cost of bidding resources away

from the production of other products.

LO2 5-12
 Producer Surplus

Carlos’s minimum acceptable price is lower than Chad’s minimum acceptable

price because Carlos is a more efficient producer than Chad, by which we mean
that Carlos produces oranges using a less-costly combination of resources than
Chad uses.

•At a price of $3.50, for instance, only Carlos would be willing to supply a bag of
oranges
•At a price of $5.50, Carlos, Courtney, and Chuck would all be willing to supply a
bag of oranges

LO2 5-13
 Producer Surplus

Producer S
surplus

P1
Equilibrium
price

Q1

LO2 5-14
 Producer Surplus
There is a direct (positive) relationship between equilibrium price and the
amount of producer surplus. Given the supply curve, lower prices reduce
producer surplus; higher prices increase it.

LO2 5-15
 Efficiency Revisited

Consumer
surplus
S

P1

Producer D
surplus

Q1

LO2 5-16
 Efficiency Revisited

• Productive efficiency is achieved because competition forces orange

growers to use the best technologies and combinations of resources
available. Doing so minimizes the per-unit cost of the output produced.
• Allocative efficiency is achieved because the correct quantity of
oranges—Q1—is produced relative to other goods and services.

The first way to see why Q1 is the allocatively efficient quantity of oranges
is to note that demand and supply curves can be interpreted as measuring
marginal benefit (MB) and marginal cost (MC). That optimal allocation is
achieved at the output level where MB=MC.

Supply curves are MC curves with the fact that demand curves are MB
curves

LO2 5-17
 Efficiency Revisited

• MB ＝ MC
• Maximum willingness to pay ＝ minimum acceptable price.
• Total surplus ( ＝ sum of consumer and producer surplus) is at a maximum.

LO2 5-18
 Efficiency Losses

a Efficiency loss S
from underproduction
Price (per bag)

d
b

D
c
Q2 Q1
Quantity (bags)

LO2 5-19
 Efficiency Losses

A consumer is willing to pay more than a producer is willing to accept,

society suffers a loss of net benefits.

A particular unit for which a consumer is willing to pay $10 and a

producer is willing to accept $6

The $4 difference between those values is a net benefit that will not be
realized if this unit is not produced

The resources that should have gone to producing this unit will go instead
to producing other products that will not generate as much utility as if
those resources had been used here to produce this unit of this product.

LO2 5-20
 Efficiency Losses

a S
Efficiency loss
from overproduction

f
Price (per bag)

b
g

D
c
Q 1 Q3
Quantity (bags)

LO2 5-21
 Efficiency Losses

The willingness to pay for such units on the part of consumers

is less than the minimum acceptable price to produce such
units on the part of producers.

The resources used to produce the bags from Q1 to Q3 could

have generated net benefits instead of net losses if they had
been directed toward producing other products.

LO2 5-22
 Private Goods

• Produced in the market by firms

• Offered for sale
• Characteristics
• Rivalry
• When one person buys and consumes a product, it is not
available for another person to buy and consume.

• Excludability
• Sellers can keep people who do not pay for a product from
obtaining its benefits.

LO3 5-23
 Public Goods
• Provided by government
• Offered for free
• Characteristics
• Nonrivalry
• One person’s consumption of a good does not preclude consumption of the
good by others. (National Defense, street lighting, environmental protection)

• Nonexcludability
• There is no effective way of excluding individuals from the
benefit of the good once it comes into existence.
• Free-rider problem
• A public good, everyone, including nonpayers, can obtain the
benefit.

LO3 5-24
 Public Goods

Once a government decides to produce a

particular public good,
•How can it determine the optimal amount that it
should produce?
–Surveys and public votes
–Reveal the WTP
–MB=MC

LO3 5-25
 Cost-Benefit Analysis
• Cost
• Resources diverted from private
good production
• Private goods that will not be
produced
• Benefit
• The extra satisfaction from the
output of more public goods

LO3 5-26
 Quasi-public goods

• Exclusion would be possible

– Education

– Highways

– Museums

• All be priced and provided by private firms

through the market system
• Underproduced by the market system

LO3 5-27
 Reallocation
• If the resources of the economy are fully employed,
government must free up resources from the production
of private goods and make them available for producing
public and quasi-public goods.

• Reduce private demand

• Tax
– Lower income and less purchasing power
– Cut their consumption and spending
– Demand will decline

LO3 5-28
 Externalities
• A cost or benefit accruing to a third party external to the transaction
• Positive externalities
• Negative externalities

LO4 5-29
 Externalities
• Negative externalities
• Supply side market failures
• Airlines: noisy jet engines
impose on people living near
airports
• Polluted air: people living
downwind
• Producers’ marginal costs are lower
than they would be if they had to
pay for those costs.
• Too much is produced
• MC>MB

LO4 5-30
 Externalities
• Positive externalities
• Demand-side market failures
• Fail to include the willingness to pay of the third parties who
receive the external benefits caused by the positive
externality.
• Vaccinations: not only yourself but also everyone else around you
• As a result, demand will be too low and vaccinations will be
underproduced.

LO4 5-31
 Government Intervention
• Correct negative externalities
• Direct controls
• Specific taxes
• Correct positive externalities
• Subsidies
• Government provision

LO4 5-32
 Government Intervention

P Negative P
externalities St St
b
a a
S S

c T
D D
Overallocation
0 0
Qo Q e Q Qo Qe Q

(a) (b)
Negative externalities Correct externality with
tax

LO4 5-33
 Government Intervention

Methods for Dealing with Externalities

Resource Allocation
Problem Outcome Ways to Correct
Negative externalities Overproduction of output 1. Private bargaining
(spillover costs) and therefore 2. Liability rules and lawsuits
overallocation of 3. Tax on producers
resources 4. Direct controls
5. Market for externality rights

Positive externalities Underproduction of output 1. Private bargaining

(spillover benefits) and therefore 2. Subsidy to consumers
underallocation of 3. Subsidy to producers
resources 4. Government provision

LO4 5-34
 Government’s Role in the Economy

• Government can have a role in

correcting externalities
• Officials must correctly identify the
existence and cause
• Has to be done in the context of
politics

LO5 5-35